If you are a business leader or an investor, you have probably heard of ESG. But what does it mean, and why does it matter? In this post, I will explain what ESG is, where it came from, and how it can benefit your company.
What is ESG?
ESG stands for environmental, social, and governance. It refers to a set of criteria that measure the environmental, social, and governance performance of companies. ESG criteria can include factors such as:
- Environmental: How a company manages its impact on the natural environment, such as its carbon footprint, waste management, resource efficiency and biodiversity.
- Social: How a company treats its stakeholders, such as its employees, customers, suppliers, communities, etc. Social factors can include labour practices, human rights, diversity and inclusion, customer satisfaction, product quality and safety.
- Governance: How a company is run internally, such as its board structure, executive compensation, business ethics, risk management, transparency and accountability.
ESG criteria are not fixed or standardized. Different investors and rating agencies may use different definitions and methodologies to assess ESG performance. However, there are some common frameworks and guidelines that can help investors and companies to align their ESG practices and reporting. For example:
- The UN Principles for Responsible Investment (PRI): A voluntary initiative that encourages investors to incorporate ESG factors into their investment decisions and ownership practices. The PRI has six principles that cover topics such as ESG integration, active ownership, disclosure, collaboration, and reporting. (UN PRI, 2006).
- The Global Reporting Initiative (GRI): A non-profit organization that provides a widely used framework for sustainability reporting. The GRI standards cover various aspects of economic, environmental, and social performance and impacts (GRI, 2020).
- The Sustainability Accounting Standards Board (SASB): A non-profit organization that develops industry-specific standards for ESG disclosure. The SASB standards focus on the material ESG issues that are most relevant and financially significant for each industry (SASB, 2020).
Where did ESG come from?
The concept of ESG is not new. It has its roots in the corporate social responsibility (CSR) movement that emerged in the 1960s and 1970s. CSR was based on the idea that businesses have a responsibility to society beyond their legal obligations and profit motives. CSR initiatives typically focus on philanthropy, community engagement and ethical conduct.
However, CSR was often seen as a separate or peripheral activity from the core business strategy. It was also criticized for being vague, superficial, or self-serving. Some companies engage in CSR to improve their public image or to comply with regulations, rather than to create genuine value for society.
In the early 2000s, a new paradigm emerged that aimed to integrate social and environmental considerations into the core business strategy and value creation process. This paradigm was shaped by two influential reports:
- Who Cares Wins (2004): A report by the UN Global Compact and more than 50 financial institutions leaders that argued that incorporating ESG factors into financial analysis and investment decisions would lead to more sustainable markets and better outcomes for society (UN Global Compact , 2004).
- The Freshfields Report (2005): A report by the UN Environment Programme Finance Initiative that concluded that considering ESG issues is part of the fiduciary duty of investors and asset managers (UNEP FI, 2005).
These reports sparked the development of the ESG concept and the launch of the UN Principles for Responsible Investment (PRI) in 2006. The PRI was a landmark initiative that brought together investors from around the world to commit to incorporating ESG factors into their investment practices (UN PRI, 2006).
Since then, ESG has gained momentum and popularity among investors and companies alike. According to the PRI, there are now over 3,000 signatories representing over $100 trillion in assets under management (PRI, 2020). According to Bloomberg Intelligence , there are now over 3,500 ESG funds globally with over $1.6 trillion in assets under management (Bloomberg Intelligence , 2020).
ESG has also become more prominent in the public discourse and policy agenda. Issues such as climate change , human rights , diversity and inclusion , corporate governance , etc., have become more urgent and visible in recent years. Governments , regulators , consumers , employees , activists , media , etc., have been putting more pressure on companies to address these issues and demonstrate their ESG performance.
How can ESG benefit you?
As a company, you may wonder how ESG can benefit you. Here are some of the potential benefits of ESG:
- Improved risk management: By considering ESG factors, you can identify and mitigate potential risks that may affect your financial performance or reputation. For example, environmental risks such as climate change, pollution, or resource scarcity may affect your operations, supply chain, or demand. Social risks such as labour disputes, human rights violations, or customer complaints may affect your stakeholder relations, brand image, or legal liabilities. Governance risks such as fraud, corruption, or mismanagement may affect your internal controls, trust, or accountability.
- Enhanced reputation: By demonstrating your ESG performance, you can enhance your reputation and credibility among your stakeholders. For example, you can attract and retain loyal customers who value your social and environmental impact. You can also attract and retain talented employees who share your values and vision. You can also build trust and goodwill with your regulators, communities, media, etc., who may support or influence your business activities.
- Increased innovation: By incorporating ESG factors into your strategy and decision-making, you can foster a culture of innovation and creativity. For example, you can develop new products or services that meet the needs and preferences of your customers who care about ESG issues. You can also improve your processes or technologies to reduce your environmental footprint or increase your efficiency. You can also explore new markets or opportunities that align with your ESG goals and values.
- Reduced costs: By adopting ESG practices, you can reduce your costs and improve your profitability. For example, you can save energy and resources by implementing energy efficiency or waste reduction measures. You can also lower your taxes or fees by complying with environmental regulations or standards. You can also avoid fines or penalties by avoiding ESG-related controversies or litigation.
- Higher returns: By investing in ESG-oriented companies or funds, you can achieve higher returns. Numerous studies have shown that ESG performance has a positive impact on financial performance. For example, a meta-study by Friede, Busch and Bassen (2015) evaluated the results of over 2,000 individual analyses of ESG performance across asset classes and regions between 1970 and 2014. It found that in 63% of the cases, ESG propositions had a positive impact on equity returns. Another study by Harvard Business School analyzed the performance of more than 2,000 U.S. companies over 21 years. It found that those firms that improved on material ESG issues significantly outperformed their competitors (Khan, Serafeim, & Yoon, 2016).
However, an analysis still to be published, prepared by Scientific Beta, finds that exchange-traded funds investing on the basis ESG criteria have not beaten the market over the past decade, with returns being marginally lower. Rather than depending on ESG scores, funds should also deep-dive into the company, study the fundamentals, and check whether the ESG criteria applied are material to the business.
Conclusion
ESG is not a fad or a buzzword. It is a fundamental aspect of how you do business and how you create value. By understanding what ESG is, where it came from, and how it can benefit you, you can make better decisions and achieve better outcomes for yourself, your stakeholders, and society at large.
If you want to learn more about how to incorporate ESG into your business strategy, contact me today. I can help you assess your current ESG performance, identify areas for improvement, and implement best practices to achieve your ESG goals.